Thursday, February 09, 2012

I agree with almost everything here. I will only type about disagreements.

First note the quick mention of "behavioral ..." Then later the casual statement that there is a mainstream consensus in favor of assuming rational expectations. This is a plain contradiction. I think it is clear what is going on -- when we discuss expectations (elicited or maybe revealed in simple experiments) we admit that there are systematic predictable deviations from rationality. Also when we attempt to explain behavior, we admit that what sure looks like the combination of that irrationality and plausible preferences is probably what it seems (although it is always possible to reconcile any behavior with full rationality).

I think it is clear what is going on. Economists like models with rational expectations and all use the same "as if" excuse. Also the Phillips curve turned out not to be an economic law refuting "Keynesian" economics (and confirming Keynes's warning which was as clear as a warning could be given the disadvantage of writing long before Phillips).

Idem with consumption. It is a fact that simple intertemporal optimizing models of consumption are rejected by the data. It is also true that they appear in DSGE models (often made equally harmless and pointless by adding on liquidity constrained agents). Now one might argue that we have moved beyond Keynes by noting factors which affect consumption which he didn't consider, then modifying the model to pick up the large empirical effect of current income. But only if you ignore The General Theory ..."'s chapter on consumption which does exactly that.

Needless to say, Keynes didn't critique econometrics, since it didn't exist in the form critiqued by Lucas when Keynes wrote. However, Lucas made no claim of originality, argued that the critique was very commonly made by the econometricians he critiqued and provided ample references to prove those claims.

So what is left which is "progressive." By the way, I hate that word with which I am mainly familiar from English translations of Trotsky. It was a magic word which explained why something was good even all the evidence at hand suggested it was terrible. Is it possible to write a defense of the rational expectations revolution without using the same magic word used to justify the Bolshevik revolution ?

What claim could possibly be weaker than "if interpreted flexibly, bring net benefits. " This is what one would write about a damaging orthodoxy -- the damage need not be denied given the word "flexibly". The benefits need not be listed, because ... I mean of course everyone who matters agrees that there are benefits.

It seems to me that with great effort by many smart people Macroeconomic theory has worked back to where it was in 1975 or so. There are many models with different implications which can be fiddled until they fit the data. None gives reliably good predictions. What progress justifies your use of "progressive" what net benefits have there been ?

Or finally, and I am asking for information and launching a challenge, what has been added to "The General Theory of Employment Interest and Money" ? I claim that any alleged new insight is either agreed to be false (but hey all models are false and the fact that RBC and New Keynesian models are false doesn't mean they aren't useful blah blah blah) or is in the book (I will provide page references).

1 comment:

This is a great challenge. I am answering off the top of my head, and will probably think of things I want to add later.

Empirical findings that seem hard to explain without forward-looking expectations: Mankiw, Miron and Weil on interest rates and the founding of the Fed (AER, 198?), Sargent on the quick remonetization of economies ending hyperinflation, and probably most importantly the empirical work in Milton Friedman's Theory of the Consumption Function.

Apropos that last, since a lot of what you say is about consumption, the recent micro research on consumption is much more nuanced than your portrayal. One of the best recent papers is Hsieh (2003, AER), which shows that the PIH works very well for large, predictable income changes but *among the same people* quite badly for small and irregular changes. This finding points to the need for refinements of models based on forward-looking expectations (like costly information processing) rather than their wholesale removal. Cochrane (1989, AER) is insightful on this point.

Apropos aggregate data and excess sensitivity, I would point to my paper with Miles Kimball (http://www.umich.edu/~mkimball/pdf/cee_oct02-3.pdf), which tries to challenge the interpretation of the famous Campbell-Mankiw papers.

Shifting from data to models qua insightful stories, I think it's pretty clear that Keynes makes sense only with substantial nominal rigidities. Now I stand foursquare for the importance of sluggish nominal wage and price adjustment in lots of circumstances and for long periods of time, but even I have a hard time saying that decade-long events like the Great Depression or Japan in the 1990s are due to price inflexibility over such long periods of time. (And yes, I know Tobin/DeLong-Summers on destabilizing price flexibility. But still.) For something on that scale, I find multiple-equilibrium models like Diamond (1982) or Benhabib-Farmer (1994) much more appealing intuitively. But I don't think one can tell those stories without rational expectations--at least not easily. Benhabib-Farmer show conditions under which the steady state becomes a sink rather than being saddlepoint-stable in the forward dynamics. But my guess is that if you put in backward-looking expectations, the sink would turn into a source, and the multiple equilibria would disappear. This is all about intuition and telling just-so stories with models rather than anything with clear empirical support, but I would say that's also the appeal of Keynes.

Thanks for making me come up with reasons why I think modern macro isn't all a waste! I look forward to your thoughts.